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Risks to Consider When Investing in ETFs

The explosive growth of the $1.3 trillion exchange traded fund industry has led to a dizzying array of product choices for investors. The following points can help outline certain risks an investor should consider before stepping into this market.

“The ETF has wide utility for a variety of investor types from small individual accounts to giant institutions. Properly selected and used they are a great vehicle,” Frank Armstrong III wrote for Forbes. [Why ETF Names Can Be Misleading]

Competition within the growing ETF industry has forced fees to lower across the board, with some providers even offering free trades for in-house brokerage accounts. Charles Schwab has even lowered some offering to cost just 4 basis points, reports Armstrong.

However, investors need to carefully sift through products to find the best ETFs. An investor should be able to watch for cautionary signs that may make them think twice before parking any capital, according to Armstrong. [Why ETFs are Here to Stay on Wall Street]

Passive exposure through a broad-based ETF such as the SPDR S&P 500 (SPY) are good bets because the fund is large enough to warrant superior liquidity, meaning an investor can get any capital out that they put in, given the proper market conditions. This also indicates that tracking error is low, and the bid-ask spread will also be comfortably low.

Since an ETF is traded like a single stock, a low bid-ask spread is desired because this will ensure that small or large orders made by other traders will not take a toll on the market or the ETF performance.

A small or niche ETF should be invested in with caution. A smaller ETF may not be liquid, so money put into the fund may not come back out when an investor is ready to redeem the purchase. In general, at least $1 million should be invested into an ETF before one even considers going in.

An exotic ETF that has low value and high costs should be avoided at all times. Not only does a fund such as this face the danger of liquidation, the investor faces the danger of lost capital. [Why ETF Closures are a Good Thing For Investors]

In general, investors should stick to ETFs that are liquid, and have enough assets to continue trading seamlessly. Broad-based, plain vanilla ETFs tend to give investors the most value and benefit for their buck.

Tisha Guerrero contributed to this article.

Full disclosure: Tom Lydon’s clients own SPY.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.